Most people have little if any understanding of bonds, and so they wind up investing in stocks and stock funds and pretty much anything else. But bonds are a major type of investment, so I created this handy-dandy guide to bonds to help you increase your investment IQ!
What exactly are bonds?
Imagine you lend your friend $1,000. Your friend agrees to pay you back in 10 years, with an extra 5% in interest each year until she is able to give you the original $1,000 after the ten years is up. That’s essentially the same way that a bond works.
I know bonds can seem scary and complicated, but they’re really quite straightforward. A bond is simply a loan you make to an issuer (corporation or government) so they can use your money. The issuer (borrower) then agrees to pay you back after a certain period of time with interest along the way.
How much time? It depends. You can have a 5 year, 10 year, or even a 30 year bond. The longer the time period, the higher the interest rate (with some exceptions), since you’re giving up your money for a longer time. Generally speaking, they make the payments on a fixed schedule, usually twice a year.
What’s the benefit of investing in bonds?
The main benefits of investing in bonds are safety and predictability. You probably know that the stock market can be pretty volatile, with large swings up and down. There can be years when you lose money, sometimes a significant amount.
When you own bonds, this is not a concern. The issuer of the bond makes regular payments to you on a fixed schedule. There is no need to worry about what’s going on in the stock market.
In addition, bonds are predictable. This is extremely helpful in budgeting and financial planning. You know exactly how much the issuer will pay you each year, so you can plan accordingly.
Quick guide to types of bonds you can invest in
There are many different types of bonds to choose from. Some of the most popular ones include:
- Corporate Bonds – Corporations issue bonds to raise money. They range in duration from 30 days to 30 years.
- Federal Government Bonds – Federal agencies issue these. These usually pay a slightly lower interest rate than corporate bonds. Can be issued for up to 30 years.
- Treasury Bonds – US Treasury issues these. Considered safest of the government bonds.
- State and Municipal Bonds – State and Local Governments issue these. Usually tax free to some extent.
- Zero Coupon Bonds – Bonds that do not pay regular interest payments each year. They simply pay you at the maturity date an amount greater than your initial investment. Any corporation or government can issue these bonds.
- Inflation Protected Bonds – Bonds that adjust the principal amount each year for the rate of inflation. They usually pay a lower interest rate than other bonds. I Bonds, issued by the US Treasury, are an example of this type of bond.
Taxable vs non-taxable bonds
As you well know, it’s pretty hard to avoid taxes. The same holds true for most bonds. The IRS and state government tax the interest you receive on bonds as regular income.
The good news is that some bonds offer a way to avoid federal and sometimes even state taxes. Bonds issued by state and local governments are “tax-exempt” bonds. That means you pay zero federal taxes on interest that you earn on them. In addition, the state that issues the bond will exempt the buyer from that state’s taxes.
For example, if the state of Nebraska issues a tax-exempt bond, Nebraska residents would not have to pay state taxes on the interest, although residents of other states still would. But anyone who invests in that bond will not have to pay federal taxes on the interest.
The main drawback to tax-exempt bonds is that they pay a significantly lower interest rate than taxable bonds. In general, tax-exempt bonds make the most sense for people in higher tax brackets, as those people will save the most.
Understanding bond ratings and why they matter
Imagine you meet a stranger on the street one day. He asks you to lend him some money. He says please, please, please, and promises that he’ll pay you back. Now, you might be a little concerned. Who in the world is this guy, and how do I know if he’ll pay me back?
Well, the world of bonds is the same way. A company or government is asking you to lend them money. They promise to pay you back, but how do you know they will? Maybe they’re about to go bankrupt. Who knows?
Bond ratings provide the answer. Special agencies assign a rating for every bond issued, based on the issuer’s credit quality and financial position. Basically, the rating tells you how likely it is that the bond issuer will actually pay you back your money.
What’s the highest rating for a bond?
AAA is the highest rating. Then comes AA. And then A. There is also BBB. As a rule, a higher bond credit rating comes with a lower interest rate — but the bond is less risky. People are willing to forego the extra interest to feel safer.
Bonds with BB ratings and below have poor credit. These are often referred to as “junk” bonds. Although, to make it sound nicer, people are now more often than not calling these bonds “high-yield” bonds.
Junk bonds come from companies that have poor credit. The risk is that they have a good chance of going bankrupt and not paying you back. But since these bonds are riskier, they also offer a much higher interest rate.
Which bonds are best for retirement accounts?
In general, you only want to own taxable bonds in a retirement account for a pretty simple reason. Tax-free bonds pay lower interest rates than taxable bonds in exchange for not paying any taxes on that interest.
But in a retirement account, even if you are lucky enough to have a good amount tucked away, any type of bond is exempt from taxes anyway. So it makes sense to take the higher yield of a taxable bond.
Are bond funds good investments?
At first glance, the answer might seem pretty simple. If one bond is a good investment, many bonds must be good too. Right?
Well, since this guide to bonds aims to increase your understanding of essential elements of investing in bonds, I’ve got to tell you that bond funds are a little more complicated than that. Maybe even more than a little.
When you own a single bond, you know exactly what your amount and interest rate are. And you also know exactly how much you will get paid each year. If you plan on keeping the bond until maturity (when you are guaranteed to get full face value), you only really need to be concerned about the company going bankrupt. And that’s pretty unlikely if you stick to buying highly rated bonds.
With a bond fund, however, the game changes. Bond funds tend to buy and sell bonds. The prices of bonds are very sensitive to interest rates, and the longer the bond duration, the more sensitive it is to interest rates.
What happens to bond fund value when interest rates change?
Basically if interest rates go up, bond prices go down, and therefore the value of the individual bonds in a bond fund decreases as well. That’s a nice way of saying that (if you sell) you’ll likely lose money in a bond fund when interest rates rise. This is especially true if it’s a fund of longer term bonds where the price can be more sensitive to rate change.
And if interest rates fall, you’ll make money in a fund (again, only if you sell it), especially in a longer term fund. So bond funds do have a place in an investment portfolio — especially if you have enough other investments to wait until rates turn around. But understand that they are certainly riskier than the relatively safe income of individual highly-rated bonds.
All this is true for individual bonds you own, also, but with individual bonds you know the exact date when you can redeem them for full value. A bond fund is a mix of bonds where you have no control over the redemption dates of the individual bonds — or how often they are bought or sold.
NOTE: Please remember that no actual money is lost or gained (despite the current value you see reported) unless you actually sell your fund.
What is a callable bond and why should I care?
Let’s say a company issues a 30 year bond with a 7% rate. Each year, they make interest payments to the bondholder. But after 10 years, the company sees that interest rates have fallen. They want to retire the 30 year bond after only 10 years, so that they can issue bonds with a lower interest rate.
Can they do that? It depends. If the bond was initially issued as a callable bond, the answer is yes. A callable bond simply means that the bond issuer can retire the bond before its maturity date.
The issuer will return the original investment amount to the bondholder, and no further interest payments are made. Usually, however, a callable bond will have a certain amount of call protection, so that the bond can’t be called during the first few years of the bond.
Why does this matter? Well, two reasons. First and foremost, callable bonds are tougher to rely on. It’s tough to use a callable bond for future income planning if the bond might be called away and you might not have it in the future. Second, callable bonds do pay a slightly higher interest rate, as they come with more risk.
What to ask your broker before investing in a bond
- What’s the bond’s credit rating?
- When is the bond’s maturity date?
- How much is the bond’s coupon?
- Is the bond callable, and if so, when?
- What’s the minimum I need to invest?
- How much does your firm charge to buy this bond for me?
Guide to bonds ~ understanding the most common terms
Coupon – Bond’s interest rate.
Maturity Date – Future date when the last payment is made and the bond ends.
Par Value – Face value of the bond, which is the initial investment amount, usually $1,000.
Issuer – Company or government that offers the bond and makes interest payments.
Credit Risk – Risk that the issuer of a bond will default and not make payments.
Default Risk – Same as credit risk.
Callable Bond – A bond that can be retired before its maturity date.
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